Article excerpt

Despite better-performing stock markets and proposed accounting changes, defined-benefit pension plans still remain underfunded and risky, these coauthors state. However, despite the fact that some companies are closing down their defined-benefit plans these plans won't be disappearing any time soon. The conclusion magnifies the need for companies and boards to manage risk even more effectively.

Canadian defined benefit (DB) pension plans have finally gotten a break. After three long years of declines, equity markets improved in both 2003 and 2004. Yet despite this improvement, DB pension plans remain surprisingly underfunded. What has happened? We conducted a study of Canadian DB pension plans to find out.

Study Highlights:

* Aggregate funded status of Canadian DB pension plans did not improve in 2004. In contrast with expectations, the aggregate funded status of the 100 largest Canadian DB pension plans deteriorated slightly in 2003 and 2004: The deficit grew from $18.5 billion in 2003 to $19.3 billion in 2004, and the number of underfunded companies increased from 77 in 2003 to 81 in 2004. This was driven, in part, by a slight decrease in the discount rate and lower contributions to pensions by plan sponsors. Further, 89 of the 100 companies in our sample offer other post-retirement benefit (OPEB) plans, all of which are underfunded because of a "payasyou-go" funding policy. These plans add an aggregate $22 billion to the overall funding deficit.

* Pension plan exposure for shareholders and cash flow. While DB pension plans do not pose a risk for all companies in our sample, they do create areas of exposure for some. Eleven companies have combined DB pension and OPEB underfunding that exceeds 25 per cent of their market capitalization. Further, 10 companies made pension contributions in 2004 exceeding 25 per cent of cash flow from operations. Six companies had significant exposure for both shareholders and cash flow. They are Abitibi Consolidated Inc., Bombardier Inc., Bowater Canada Inc., Inco Ltd., NorskeCanada and Stelco Inc.

* New asset allocation disclosures. For the first time, Canadian companies were required to disclose the allocation of their pension plan assets. The average Canadian portfolio was allocated as follows: 57 per cent equities, 38 per cent debt securities, 1 per cent real estate, and 4 per cent other, including cash. This sample portfolio is somewhat more conservative than the average portfolio of S&P 500 firms with DB pensions. In this latter case, the allocation is 62 per cent equity, 29 per cent debt securities, 3 per cent real estate, and 6 per cent other. Disclosures of target allocations for Canadian firms for 2005 indicate that they are planning a slight reduction in the allocation to equity, on average.

* Pension Accounting. Changes in accounting rules are being considered in the U.S. and Canada. The elimination of the smoothing permitted under current accounting rules could bring an additional aggregate $26.2 billion of off-balance-sheet debt back onto the balance sheet.

The staying power of deficits

In July 2005, Standard & Poor's reported that the status of pension funds in the S&P 500 failed to improve in 2004, with the aggregate underfunding remaining basically unchanged, at $164 billion. This compared with the $165 billion reported a year earlier. In a study based on the 2003 and 2004 financial statements of the 100 largest Canadian DB pension plans, we found that the status actually deteriorated slightly, with the aggregate deficit increasing from $18.5 billion to $19.3 billion. In fact, the number of companies that were underfunded increased from 77 in 2003 to 81 in 2004.

These findings are surprising given the healthier equity markets; however, there are additional factors that affect the funded status of a pension plan. In 2004, the pension liability (or benefit obligation) grew 11.5 per cent-from $156. …

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